BRUEGEL ESSAY AND LECTURE SERIESBRUEGEL ESSAY AND LECTURE SERIES

INVESTING FOR THE COMMON GOOD: A SUSTAINABLE FINANCE FRAMEWORKDirk Schoenmaker

Traditional finance focuses solely on financial return and risk. By contrast, sustainable finance considers financial, social and environmental returns in combination. This essay provides a new framework for sustainable finance highlighting the move from the narrow shareholder model to the broader stakeholder model, aimed at long-term value creation for the wider community. Major obstacles to sustainable finance are short-termism and insufficient private efforts. To overcome these obstacles, this essay develops guidelines for governing sustainable finance.

BRUEGEL ESSAY AND LECTURE SERIESInvesting for the common good: a sustainable finance framework

Dirk Schoenmaker

Editor: Stephen Gardner

© Bruegel 2017. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted in the original language without explicit permission provided that the source is acknowledged. Opinions expressed in this publication are those of the author alone.

Bruegel33 rue de la Charité, Box 41210 Brussels, Belgiumwww.bruegel.orgISBN: 978-9-078910-43-5

ACKNOWLEDGEMENTS

The author would like to thank Patrick Bolton, Mathijs

Cosemans, Jaap van Dam, Maria Demertzis, Mathijs van Dijk,

Frank Elderson, Adrian de Groot Ruiz, Han van der Hoorn,

Steve Kennedy, Eloy Lindeijer, Jaap van Manen, Herman

Mulder, Sanne Nagelhout, Nick Robins, Eva Rood, Paul de

Ruijter, Frederic Samama, Willem Schramade, Bernd Jan

Sikken, Hans Stegeman, Thomas Steiner, Simone Tagliapietra,

Christian Thimann, Rens van Tilburg, Nicolas Véron, Herman

Wijffels, Guntram Wolff, Georg Zachmann and Simon Zadek

for stimulating discussions on sustainable finance. He is also

grateful to participants at the Bruegel Research Seminar and

the Erasmus Finance Brown Bag Seminar for useful com-

ments and to Enrico Nano for excellent research assistance.

A slightly longer version of this essay will be published by

the Rotterdam School of Management, Erasmus University.

CONTENTS

Foreword 5

1 Introduction 7

2 Sustainability challenges 14

2.1 Environmental challenges 14

2.2 Social foundations 16

2.3 Sustainable development 21

3 A framework for sustainable finance 26

3.1 The role of the financial system 26

3.2 Three stages of sustainable finance 28

3.3 SF 1.0: Profit maximisation, while avoiding ‘sin’ stocks 30

3.4 SF 2.0: Internalisation of externalities to avoid risk 32

3.5 SF 3.0: Contributing to sustainable development, 37

while observing financial viability

3.6 Comparing the stages: where are we? 39

4 Obstacles to sustainable finance 43

4.1 Insufficient private effort 46

4.2 Short-termism 49

5 Coalition for sustainable finance 60

5.1 Coalitions as an alternative 60

5.2 Reasons to join coalitions for sustainable finance 65

Conclusions 71

References 73

FOREWORD

The issue of sustainable development has multiple aspects,

all of which need to be considered if sustainability is to be

guaranteed. On the environmental front, climate change

and depletion of natural resources are two factors that are

threatening the earth’s ability to regenerate. On the economic

front, development that does not pay sufficient attention

to income inequality and provision of basic needs to all is

a process in danger of imploding. This essay explores the

role that finance can play to ensure that investment protects

the environment and promotes economic systems that are

internally sustainable.

Dirk Schoenmaker argues that seeing the role of finance

as one of allocating funding to productive investments in

a narrow sense is no longer appropriate. What constitutes

‘productive’ cannot be independent of a project’s environ-

mental and socio-economic impact because there are often

trade-offs between short-term profits and long-term impact.

What might appear to be a profitable project over a given

time period could have negative impacts that might only

become apparent in the longer term. This essay discusses

these trade-offs in the context of the conflicting objectives

of shareholders and other stakeholders: the motivation of

6

the former to generate profits might at times jeopardise the

long-term interests of the latter. This essay shows how that is

a consequence of short-termism and a failure to act with the

collective interest in mind. But if sustainability is paramount,

as it should be, then the shareholders’ and stakeholders’

motives need to be better aligned.

This essay provides a framework for moving in this direc-

tion and offers guidelines to counter short-termism, with an

emphasis on incentive-compatible measures for all. Moving

from traditional to sustainable finance means having to coun-

ter attitudes that are embedded in the ways our economic

systems are organised. Shifting away from them requires

both new ways of operating but, importantly, new underlying

principles that put sustainability centre stage to guide our

thinking. It is important that we put this process in motion,

and the earlier the better.

Maria Demertzis, Deputy Director of Bruegel

Brussels, July 2017

1 INTRODUCTION

The Industrial Revolution, and the development of

production processes dependent on fossil fuels that it

triggered, has brought prosperity in the form of economic

and population growth. At the same time, this evolution

away from a previously ‘empty’ world1 with abundant

natural resources has intensified social and environmental

challenges. Mass production in a competitive economic

system has led to long working hours, underpayment and

child labour, first in the developed world and later relocated

to the developing world. Social regulations have been

increasingly introduced to counter these practices and to

promote decent work and access to education and health

care. Mass production and consumption is also stressing

the Earth system through pollution and depletion of

natural resources. Climate change is now the most pressing

ecological constraint.

There is broad agreement on the need for a transition

to a low-carbon, circular economy to overcome these

environmental challenges. While an early transition – with

1 In the empty world scenario, the economy is very small relative to the larger environmental ecosystem and the environment is thus not scarce. Continued growth of the physical economy into a non-growing ecosystem will eventually lead to the ‘full world economy’ (Daly and Farley, 2011).

8

substantial cuts in carbon emissions starting in 2020 –

would allow for production and consumption patterns to

be gradually adjusted, a late transition – starting in 2030 – is

likely to cause sudden shocks and lead to the stranding of

assets that have lost their productive value (ASC, 2016). Many

natural resources companies are still in denial, irrationally

counting on a late and gradual transition. To guide the

transformation towards a sustainable and inclusive economy,

the United Nations (2015) has developed the 2030 Agenda

for Sustainable Development, which will require behavioural

change.

Sustainable development is an integrated concept with

three aspects: economic, social and environmental. This

essay starts by explaining the sustainability challenges that

society is facing. On the environmental front, climate change,

land-use change, biodiversity loss and depletion of natural

resources are destabilising the Earth system. Next, poverty,

hunger and lack of health care are signs that many people live

below minimum social standards. Sustainable development

means that current and future generations should have the

resources they need, such as food, water, health care and

energy, without stressing the Earth system.

Why should finance contribute to sustainable develop-

ment? The main task of the financial system is to allocate

funding to its most productive use. Finance can play a role

in allocating investment to sustainable companies and

projects and thus accelerate the transition to a low-carbon,

circular economy. Sustainable finance considers how finance

(investing and lending) interacts with economic, social and

environmental issues. In the allocation role, finance can

assist in making strategic decisions on the trade-offs between

9

sustainable goals. Moreover, investors can exert influence

over the companies they invest in. Long-term investors can

thus steer companies towards sustainable business practices.

Finally, finance is good at pricing risk for valuation purposes

and can thus help to deal with the inherent uncertainty about

environmental issues, such as the impact of carbon emissions

on climate change. Finance and sustainability both look to

the future.

Table 1: A framework for sustainable finance

Sustainable finance typology

Value createdRanking of

factorsHorizon

Sustainable Finance 1.0

Shareholder value F > S and E Short term

Sustainable Finance 2.0

Stakeholder value T = F + S + EMedium

term

Sustainable Finance 3.0

Common good value

S and E > F Long term

Source: Bruegel. Note: F = financial value; S = social impact; E = environmental impact; T = total value. At Sustainable Finance 1.0, the maximisation of F is subject to minor S and E constraints.

The thinking about sustainable finance has gone through

different stages over the last few decades (see Table 1). The

focus is gradually shifting from short-term profit towards

long-term value creation. This essay analyses these stages

and provides a new framework for sustainable finance.

Financial and non-financial firms traditionally adopt the

shareholder model, with profit maximisation as the main

goal. A first step in sustainable finance (1.0 in Table 1) would

be for financial institutions to avoid investing in companies

with very negative impacts, such as tobacco, cluster bombs

or whale hunting. Some firms are starting to include social

10

and environmental considerations in the stakeholder

model (Sustainable Finance 2.0). We highlight the tension

between the shareholder and stakeholder models. Should

policymakers allow a shareholder-oriented firm to take

over a stakeholder-oriented firm? Or do we need to protect

firms that are more advanced in sustainability? Another key

development is the move from risk to opportunity. While

financial firms have started to avoid (very) unsustainable

companies from a risk perspective (Sustainable Finance 1.0

and 2.0), the frontrunners are now increasingly investing in

sustainable companies and projects to create value for the

wider community (Sustainable Finance 3.0).

This essay also looks at the obstacles to the adoption of

sustainable finance, including a failure to act collectively and

short-termism. To address the shortfall in corporate efforts,

governments should ultimately translate the aggregate long-

term social and environmental preferences of their citizens

into appropriate regulation and taxation (eg appropriate

carbon taxes). Finance is about anticipating such policies

and incorporating expectations into today’s valuations for

investment decisions.

Possible solutions to counter short-termism are a more

long-term oriented corporate reporting structure (moving

away from quarterly reporting), pay structure for executives

(eg deferred rewards and clawback provisions), invest-

ment performance horizons (moving away from quarterly

benchmarking) and incentives for long-term investors (eg

loyalty shares). It is important to design these measures in an

incentive-compatible manner. In this way, executives’ and

investors’ horizons can become more aligned and focused on

the longer term.

11

Finally, this essay outlines how long-term (institutional)

investors can build effective coalitions to accelerate the

transformation to sustainable development. While the early

adopters of sustainability are primarily based in Europe,

major players in North America and Asia have also joined

the emerging coalitions for sustainable finance. Sustainable

investing has thus become a global force. In this essay, we

develop guidelines for sustainable finance, which are sum-

marised in Box 1.

Box 1: Guidelines for sustainable finance

Social and environmental externalities are by their nature

not incorporated in the decisions taken by companies and

investors. As most externalities play out in the medium to

long term, the problem is aggravated by the short horizon

executives and investors work to. Moreover, the efficient mar-

kets hypothesis, which states that stock prices incorporate all

relevant information and thus reflect the fundamental value

of the firm, reinforces the focus on stock price as a central

performance measure for executive and investor perfor-

mance.

This essay develops the following guidelines to govern

sustainable finance:

Company perspective

• Move from shareholder to stakeholder value approach,

whereby a company balances the interests of all its stake-

holders: customers, employees, suppliers, shareholders

and the community.

• More broadly, corporates should strive for long-term

12

value creation for the common good (ie what is shared

and beneficial for all or most members of a given

community).

Lengthening executive and investors’ horizons

• To counter short-termism, executive and investor hori-

zons should be aligned to the long term.

• On the executive side, a more long-term oriented

reporting structure (moving away from quarterly

reporting) and pay structure for executives (eg deferred

rewards and clawback provisions) would reduce short-

termism.

• More generally, integrated reporting by companies facil-

itates social and environmental transparency and thus

increases the accountability of executives.

• On the investment side, a more long-term investment

performance horizon (moving away from quarterly

benchmarking) and incentives for long-term investors (eg

loyalty shares) would promote long-term investment.

Engagement

• To become a force for long-term value creation, long-term

(institutional) investors should build investor coalitions to

cooperate on engagement with corporates on social and

environmental issues.

Market efficiency and liquidity

• Raise awareness of alternative theories of market

efficiency.

• The dominant view of liquidity (the degree to which an

asset can be quickly bought or sold in the market without

13

affecting the asset’s price) favours listed securities and is

based on the efficient markets hypothesis.

• An alternative view is the adaptive markets hypothe-

sis, which implies that the degree of market efficiency

depends on an evolutionary model of individuals adapt-

ing to a changing environment. That can explain why

new risks, such as environmental risks, are not (yet) fully

priced in.

Supervisory treatment

• Reduce the supervisory bias towards favouring ‘liquid’

investments (which are listed) and allow for ‘buy and

hold’ investments. An example is the introduction of sus-

tainable retail investment funds, based on sustainability

criteria (instead of transferability).

• Financial institutions should be stress-tested to identify

overexposure to and concentration in carbon-intensive

assets. These carbon stress tests make use of various

climate scenarios, including the adverse scenario of late

adjustment resulting in a ‘hard landing’, and have a long

horizon over which adverse events could occur.

2 SUSTAINABILITY CHALLENGES

2.1 Environmental challenges

There is increasing evidence that human activities are

affecting the Earth system, threatening the planet’s future

liveability. The planetary boundaries framework of Steffen et

al (2015) defines a safe operating space for humanity within

the boundaries of nine productive ecological capacities of the

planet. The framework is based on the intrinsic biophysical

processes that regulate the stability of the Earth system at the

planetary scale. The green zone in Figure 1 is the safe operat-

ing space, yellow represents the zone of uncertainty (increas-

ing risk) and red indicates the zone of high risk.

Applying the precautionary principle, the planetary

boundary itself lies at the intersection of the green and yellow

zones. To illustrate how the framework works, we look at the

control variable for climate change, the atmospheric concen-

tration of greenhouse gases. The zone of uncertainty ranges

from 350 to 450 parts per million (ppm) of carbon dioxide.

At 399 ppm in 2015, we have already crossed the planetary

boundary of 350 ppm. The upper limit of 450 ppm is con-

sistent with the goal (at a fair chance of 66 percent) to limit

global warming to 2o Celsius above the pre-industrial level

and lies at the intersection of the yellow and red zones.

15

Figure 1: The planetary boundaries

Source: Reproduced with permission from Steffen et al (2015).

The current linear production and consumption system is

based on extraction of raw materials (take), processing into

products (make), consumption (use) and disposal (waste).

Traditional business models centred on a linear system

assume the ongoing availability of unlimited and cheap

natural resources. This is increasingly risky because non-re-

newable resources, such as fossil fuels, minerals and metals,

are increasingly under pressure, while potentially renewable

resources, such as water, forests and fisheries, are declining in

their extent and regenerative capacity.

With this linear economic system, we are crossing plane-

tary boundaries beyond which human activities might dest-

abilise the Earth system. In particular, the planetary bounda-

ries of climate change, land-system change, biodiversity loss

16

(terrestrial and marine) and biochemical flows (nitrogen and

phosphorus, mainly because of intensive agricultural prac-

tices) have been crossed (see Figure 1). A timely transforma-

tion towards an economy based on sustainable production

and consumption, including use of renewable energy and

reuse of materials, can mitigate these risks to the stability of

the Earth system.

2.2 Social foundations

Human rights provide the essential social foundation for all

people to lead lives of dignity and opportunity. Human rights

norms assert the fundamental moral claim each person has

to life’s essentials, such as food, water, health care, education,

freedom of expression, political participation and personal

security. In the run-up to the 2012 Rio+20 Conference on Sus-

tainable Development, the social foundations were defined

as the eleven top social priorities, grouped into three clusters,

focused on enabling people to be: 1) well: through food

security, adequate income, improved water and sanitation

and health care; 2) productive: through education, decent

work, modern energy services and resilience to shocks; and

3) empowered: through gender equality, social equity and

having political voice (Raworth, 2012).

While these social foundations only set out the minimum

of every human’s claims, sustainable development envisions

people and communities prospering beyond this, leading

lives of creativity and fulfilment. Sustainable development

combines the concept of planetary boundaries with the

complementary concept of social foundations or bounda-

ries. Sustainable development means that current and future

generations have the resources needed, such as food, water,

17

health care and energy, without stressing the Earth system

processes (Raworth, 2012).

But many people still live below the social foundations of

no hunger, no poverty (a minimum income of $1.25 a day),

access to education and access to clean cooking facilities.

More broadly, political participation, which is the right of

people to be involved in decisions that affect them, is a basic

value of society. The UN’s Universal Declaration of Human

Rights states that “recognition of the inherent dignity and of

the equal and inalienable rights of all members of the human

family is the foundation of freedom, justice and peace in

the world”. Human rights are an important social founda-

tion. Next, decent work can lift communities out of poverty

and underpins human security and social peace. The 2030

Agenda for Sustainable Development (United Nations, 2015;

see below) places decent work for all people at the heart of

policies for sustainable and inclusive growth and develop-

ment. Decent work has several aspects: a basic living income

(which depends on a country’s basic living basket), no

discrimination (eg on the basis of gender, race or religion), no

child labour, health and safety and freedom of association.

From a societal perspective, it is important for business

to respect these social foundations and to ban underpay-

ment, child labour and human right violations, which are still

happening in developing countries. A case in point is the use

of child labour in factories in developing countries producing

consumer goods, like clothes and shoes, to be sold by multi-

national companies in developed countries. These factories

often lack basic worker safety features (Box 3). Another exam-

ple is the violations of the human rights of indigenous people,

often in combination with land degradation and pollution, by

18

extractive companies in the exploration and exploitation of

fossil fuels, minerals and other raw materials.

To highlight the tension between unbridled economic

growth and sustainable development, we provide two

examples. Box 2 describes the Deepwater Horizon oil spill

in the Gulf of Mexico. Box 3 shows the impact of the col-

lapse of a factory building in Bangladesh. These examples

have in common underinvestment in safety to increase

short-term profits.

Box 2: The Deepwater Horizon oil spill

The oil spill from the Deepwater Horizon drilling platform

began on 20 April 2010, in the British Petroleum-operated

Macondo Prospect in the Gulf of Mexico. An explosion on

the drilling rig killed eleven workers and led to the largest

accidental marine oil spill in the history of the petroleum

industry. The US Government estimated the total discharge

at 4.9 million barrels. After several failed efforts to contain the

flow, the well was declared sealed on 19 September 2010.

A massive response ensued to protect beaches, wetlands

and estuaries from the spreading oil utilising skimmer

ships, floating booms, controlled burns and oil dispersant.

Oil clean-up crews worked on 55 miles of the Louisiana

shoreline until 2013. Oil was found as far from the Deepwa-

ter Horizon site as the waters off the Florida Panhandle and

Tampa Bay, where oil and dispersant mixture was embed-

ded in the sand. The months-long spill, along with adverse

effects from the response and clean-up activities, caused

extensive damage to marine and wildlife habitats and the

fishing and tourism industries.

19

Numerous investigations explored the causes of the

explosion and record-setting spill. Notably, the US govern-

ment’s September 2011 report pointed to defective cement

on the well, faulting mostly BP, but also rig operator Transo-

cean and contractor Halliburton. Earlier in 2011, a National

Commission (2011) likewise blamed BP and its partners for

a series of cost-cutting decisions and an inadequate safety

system, but also concluded that the spill resulted from

“systemic” root causes and that without “significant reform

in both industry practices and government policies, might

well recur”.

20

Box 3: Rana Plaza factory collapse

The Rana Plaza collapse was a disastrous structural failure

of an eight-storey commercial building that occurred on 24

April 2013 in Bangladesh. The collapse of the building caused

1,129 deaths, while approximately 2,500 injured people were

rescued from the building alive. It is considered the deadliest

garment-factory accident in history and the deadliest acci-

dental structural failure in modern human history.

The building contained clothing factories, a bank,

apartments, and several shops. The shops and the bank on

the lower floors were immediately closed after cracks were

discovered in the building. The building’s owners ignored

warnings to evacuate the building after cracks in the structure

appeared the day before the collapse. Garment workers, earn-

ing €38 a month, were ordered to return the following day,

and the building collapsed during the morning rush-hour.

The factories manufactured clothing for brands including

Benetton, Bonmarché, the Children’s Place, El Corte Inglés,

Joe Fresh, Monsoon Accessorize, Mango, Matalan, Primark

and Walmart.

21

2.3 Sustainable development

To guide the transformation towards a sustainable and inclu-

sive economy, the United Nations has developed the 2030

Agenda for Sustainable Development (UN, 2015). The 17 UN

Sustainable Development Goals are intended to stimulate

action over the 2015-30 period in areas of critical importance

for humanity and the planet (see Box 4 for an overview). To

facilitate implementation, the 17 high level goals are broken

down into 169 targets (see https://sustainabledevelopment.

un.org/topics/sustainabledevelopmentgoals). The UN Sus-

tainable Development Goals address challenges at the levels

of the economy, society and the environment (or biosphere).

Figure 2 illustrates the three levels and the ranking

between them. A liveable planet is a precondition (founda-

tion) for humankind to thrive. Next, we need a cohesive and

inclusive society to organise production and consumption in

order to ensure enduring prosperity for all. In their seminal

book Why nations fail, Acemoglu and Robinson (2012) show

that political institutions that promote inclusiveness generate

prosperity. Inclusiveness allows everyone to participate in

economic opportunities. Next, there can be resource con-

flicts: unequal communities might disagree over how to share

(and finance) public goods. These conflicts, in turn, break

social ties and undermine the formation of trust and social

cohesion (Barone and Mocetti, 2016).

22

Box 4: UN Sustainable Development Goals (Source: UN, 2015)

The United Nations has developed 17 Sustainable Devel-

opment Goals (SDGs) as part of the 2030 Sustainable

Development Agenda. Following Rockström and Sukhdev

(2015), we classify the SDGs according to the levels of the

economy, the society and the environment. Nevertheless,

we stress that the SDGs are interrelated. A case in point

is the move to sustainable consumption and production

(economic goal 12) and sustainable cities (societal goal

11), which are instrumental to combat climate change

(environmental goal 13).

Economic goals

• Goal 8: Promote sustained, inclusive and sustainable

economic growth, full and productive employment and

decent work for all

• Goal 9: Build resilient infrastructure, promote inclusive

and sustainable industrialisation and foster innovation

• Goal 10: Reduce inequality within and among countries

• Goal 12: Ensure sustainable consumption and production

patterns

Societal goals

• Goal 1: End poverty in all its forms everywhere

• Goal 2: End hunger, achieve food security and improved

nutrition and promote sustainable agriculture

• Goal 3: Ensure healthy lives and promote well-being for

all at all ages

• Goal 4: Ensure inclusive and equitable quality education

and promote lifelong learning opportunities for all

23

• Goal 5: Achieve gender equality and empower all women

and girls

• Goal 7: Ensure access to affordable, reliable, sustainable

and modern energy for all

• Goal 11: Make cities and human settlements inclusive,

safe, resilient and sustainable

• Goal 16: Promote peaceful and inclusive societies for

sustainable development, provide access to justice for all

and build effective, accountable and inclusive institutions

at all levels

Environmental goals

• Goal 6: Ensure availability and sustainable management

of water and sanitation for all

• Goal 13: Take urgent action to combat climate change and

its impacts

• Goal 14: Conserve and sustainably use the oceans, seas

and marine resources for sustainable development

• Goal 15: Protect, restore and promote sustainable use

of terrestrial ecosystems, sustainably manage forests,

combat desertification, and halt and reverse land

degradation and halt biodiversity loss

Overall goal

• Goal 17: Strengthen the means of implementation and

revitalise the Global Partnership for Sustainable Devel-

opment

24

Figure 2: Sustainable development challenges at different levels

Source: Adapted from Rockström and Sukhdev (2015).

While it is tempting to start working on partial solutions

at each level, the environmental, societal and economic

challenges are interlinked. It is important to embrace an

integrated social-ecological system perspective (Norström et

al, 2014). Such an integrated system perspective highlights

the dynamics that such systems entail, including the role of

ecosystems in sustaining human wellbeing, cross-system

interactions and uncertain thresholds.

A well-known example of cross-system interaction is the

linear production of consumption goods at the lowest cost

contributing to ‘economic growth’, while depleting natural

resources, using child labour and producing carbon emis-

sions and other waste2.

Another cross-system interaction is global warming

leading to more and more-intense disasters, such as storms,

flooding and droughts. The low and middle-income countries

2 We use carbon emissions as shorthand for greenhouse gas emissions, which include carbon dioxide (CO2), methane (CH4) and nitrous oxide (N2O).

Economy

Society

Environment

25

around the equator are especially vulnerable to these extreme

weather events, which could damage a large part of their

production capacity. The temporary loss of tax revenues and

increase in expenditures to reconstruct factories and infra-

structure might put vulnerable countries into a downward

fiscal and macro-economic spiral with an analogous increase

in poverty (Schoenmaker and Zachmann, 2015). Social and

environmental issues are thus interconnected, whereby the

poor in society are more dependent on ecological services

and are less well protected against ecological hazards.

An example of an uncertain threshold combined with

feedback dynamics is the melting threshold of the Greenland

ice sheet. New research has found that it is more vulnerable

to global warming than previously thought. Robinson, Calov

and Ganopolski (2012) calculate that a 0.9°C global temper-

ature rise from today’s levels could lead the Greenland ice

sheet to melt completely. Such melting would create further

climate feedbacks in the Earth ecosystem, because the melt-

ing of the ice cap could increase the pace of global warming

(by reducing the refraction of solar radiation, which is 80

percent from ice, compared with 30 percent from bare earth

and 7 percent from the sea) and of rising sea levels. These

feedback mechanisms are examples of tipping points and

shocks, which might happen.

Although sustainable development is a holistic concept,

Norström et al (2014) argue for the addressing of trade-

offs between the level of ambition of economic, social and

environmental goals and the feasibility of reaching them,

recognising biophysical, social and political constraints.

3 A FRAMEWORK FOR SUSTAINABLE FINANCE

3.1 The role of the financial system

How can the financial system facilitate decision-making on

the trade-offs between economic, social and environmental

goals? Levine (2005) lists the following functions of the finan-

cial system:

• Produce information ex ante about possible investments,

and allocate capital;

• Monitor investments and exert corporate governance

after providing finance;

• Facilitate the trading, diversification and management of

risk;

• Mobilise and pool savings;

• Ease the exchange of goods and services.

The first three functions are particularly relevant for

sustainable finance. The allocation of funding to its most

productive use is a key role of finance. Finance is therefore

well positioned to assist in making strategic decisions on the

trade-offs between sustainability goals. While broader con-

siderations guide an organisation’s strategy on sustainability,

funding is a requirement for reaching sustainability goals.

27

Finance plays this role at different levels. In the financial

sector, banks, for example, define their lending strategies

regarding which sectors and projects are eligible for lending

and which not. Similarly, investment funds set their invest-

ment strategies, which direct choices over which assets to

invests in and which assets to not invest in. The financial

sector can thus play a leading role in the transition to a low

carbon, circular economy. If the financial sector chooses to

finance sustainable companies and projects, they can accel-

erate the transition.

In terms of monitoring their investments, investors also

can have an influence over the companies in which they

invest. Investors thus have a powerful role in controlling and

directing corporate boards. The governance role also involves

balancing the many interests of a corporation’s stakeholders.

In section 3.2, we review the progressive thinking about how

interests should be balanced, including the interests of the

environment and society. A rising trend in sustainable invest-

ment is engagement with companies in the hope of reducing

the risk of adverse events occurring in those companies.

Finance is good at pricing the risk of future cash flows for

valuation purposes. As there is inherent uncertainty about

environmental issues (eg exactly how rising carbon emissions

will affect the climate, and the timing and shape of climate

mitigation policies), risk management can help to deal with

these uncertainties. Scenario analysis is increasingly used to

assess the risk and valuation under different scenarios (eg cli-

mate scenarios; see Caldecott et al, 2014). When the (poten-

tial) price of carbon emissions in the future becomes clearer,

investors and companies have an incentive to reduce these

emissions. The key challenge is to take a sufficiently long

28

horizon, as sustainability is about the future. The remainder

of this section and section 4 discuss the appropriate hori-

zon for sustainable finance and ways to overcome the bias

towards short-termism.

3.2 Three stages of sustainable finance

How can finance support sustainable development? Figure 3

shows our framework for managing sustainable development

at the different levels. As we have argued, there are interac-

tions between the levels. It is thus important to choose an

appropriate combination of the financial, social and environ-

mental aspects.

Figure 3: Managing sustainable development

The concept of sustainable finance has evolved as part

of the broader notion of business sustainability over the last

few decades (eg Whiteman et al, 2013). Table 2 shows our

typology for sustainable finance. The evolution highlights the

broadening from shareholder value to stakeholder value (or

triple bottom line: people, planet, profit). The final stage looks

at the creation of common good value. To avoid the dichot-

Economy

Society

Environment

Financial return and risk: F

Impact on society: S

Impact on environment: E

29

omy of private versus public goods, we use the term common

good referring to what is shared and beneficial for all or most

members of a given community. Next, the ranking indicates a

shift from economic goals first to societal and environmental

challenges (the common good). Importantly, the horizon

is broadened from short term to long term as each stage is

passed through.

In traditional finance, shareholder value is maximised by

looking for the optimal financial return and risk combination.

Table 2 labels this the finance-as-usual approach. Although

shareholder value should also look at the medium to long

term, there are built-in incentives for short-termism, such as

quarterly financial reporting and monthly/quarterly bench-

marking of investment performance (see section 4). Finance-

as-usual is consistent with the argument of Friedman (1970)

that “the business of business is business” and the only social

responsibility of business is to use its resources and engage

in activities designed to increase its profits as long as it stays

within the rules of the game. Friedman (1970) argues that it is

the task of the government to take care of social and environ-

mental goals and set the rules of the game for sustainability.

We however argue, in line with the United Nations’ Sustain-

able Development Goals, that sustainable development is a

joint responsibility of governments, companies and citizens.

We do not see a case for not integrating sustainability into

strategy and finance.

Sections 3.3 to 3.5 discuss our three stages of Sustainable

Finance (SF) (Table 2). The stages move from finance first, to

all aspects equal, and finally to social-environmental impact

first (the ranking of factors in the third column of Table 2).

30

Table 2: Framework for Sustainable Finance

Sustainable finance typology

Value createdRanking of factors

Optimisation Horizon

Finance-as-usualShareholder

valueF Max F Short term

Sustainable Finance 1.0

Refined shareholder

value

F > S and E

Max F subject to S

and EShort term

Sustainable Finance 2.0

Stakeholder value

T = F + S + E

Optimise TMedium

term

Sustainable Finance 3.0

Common good value

S and E > F

Optimise S and E

subject to FLong term

Source: Bruegel. Note: F = financial value; S = social impact; E = environmental impact; T = total value. At Sustainable Finance 1.0, the maximisation of F is subject to minor S and E constraints.

3.3 SF 1.0: Profit maximisation, while avoiding ‘sin’

stocks

A first step in sustainable finance is that financial institutions

avoid investing in, or lending to, so-called ‘sin’ companies.

These are companies with very negative impacts. In the

social domain, they include, for example, companies that

sell tobacco, anti-personnel mines and cluster bombs or that

exploit child labour. In the environmental field, classic exam-

ples of negative impacts are waste dumping and whale hunt-

ing. More recently, some financial institutions have started to

put coal, and even the broader category of fossil fuels, on the

exclusion list because of carbon emissions. These exclusion

lists are often triggered under pressure from non-governmen-

tal organisations, which use traditional and social media for

their messages (Dyllick and Muff, 2016).

31

But the effects of exclusion and divestment are limited

(Skancke, 2016). From a general equilibrium perspective,

there is willing buyer for every share a financial institution

sells. Divestment by a growing number of investors might

reduce a company’s share price, which might in turn make

raising new capital through issuing shares more expensive

for the company. However, this is a minor source of funding

compared to retained earnings and debt financing. Another

effect is that divestment may stigmatise a sector or companies

to the point where they lose their social license to operate

(see section 3.5). This might lead to less investment in that

sector. An exclusion criterion targeted at a sector or the worst

performers within a sector could have an effect through set-

ting a norm for acceptable standards.

A slightly more positive variant of the refined shareholder

value approach is that financial institutions and companies put

systems in place for energy and emissions management, sus-

tainable purchasing, green IT, green building and infrastructure,

diversity and old age employment. The underlying objective

of these activities remains economic. Though introducing sus-

tainability into business might generate positive side-effects for

some sustainability aspects, the main purpose is to reduce costs

and business risks, to improve reputation and attractiveness

for new or existing human talent, to respond to new customer

demands and segments, and thereby to increase profits, market

positions, competitiveness and shareholder value in the short

term. Business success is still evaluated from a purely economic

point of view and remains focused on serving the business itself

and its economic goals (Dyllick and Muff, 2016). Shareholder

value or profit maximisation is still the guiding principle for the

organisation, though with some refinements.

32

3.4 SF 2.0: Internalisation of externalities to avoid risk

In Sustainable Finance 2.0, financial institutions explicitly

incorporate the negative social and environmental externali-

ties into their decision-making. Over the medium to long-

term horizon, these externalities might become priced (eg

a carbon tax) and/or might impact negatively on an institu-

tion’s reputation. Incorporating the externalities thus reduces

the risk that financial investments become unviable. This

risk is related to the maturity of the financial instrument, and

is thus greater for equity (stocks) than for debt (bonds and

loans). On the positive side, internalisation of externalities

helps financial institutions and companies to restore trust,

which is the mirror image of reputation risk.

Attaching a financial value to social and environmen-

tal impacts facilitates the optimisation process among

the different aspects (F, S, E). Innovations in technology

(measurement, information technology, data management)

and science (life-cycle analyses, social life-cycle analyses,

environmentally extended input-output analysis, environ-

mental economics) make the monetisation of social and

environmental impacts possible (True Price, 2014). In this

way, the total or true value T can be established by summing

the financial, social and environmental values in an integrat-

ing way. Financial institutions and companies use a private

discount rate (which is higher than the public discount rate

because of uncertainties) to discount future cash flows. As

social and, in particular, environmental impacts become

manifest over a longer horizon and are also more uncertain

than financial impacts, private discounting leads to a lower

weighting of social and environmental value than financial

value.

33

The methodology for calculating the total value involves

measuring, monetising and balancing financial and non-fi-

nancial values (True Price, 2014; KPMG, 2014). Figure 4

illustrates the four steps to calculate the total value:

1. We start by calculating the financial value and quantifying

and monetising the social and environmental impacts

(bar 1);

2. We then internalise the social and environmental exter-

nalities and calculate the total value as the sum of the

values (bar 2);

3. Next, we adjust to account for the combination of the

three factors. As explained in section 2, there are several

non-linear trade-offs between the economic, social and

environmental aspects of corporate investment. The

monetisation helps corporations to find the optimal com-

bination of the three factors. In our example, the corpora-

tion is able to reduce both the social and environmental

impact from 3 to 1 at an extra cost of 1 (bar 3) by adapting

its production process3;

4. Finally, we calculate the total value T* (bar 4).

3 It should be noted that reducing the social and environmental impact is not always costly. With the rapidly declining cost of solar energy for example, we are getting close to the point where the use of renewable energy can reduce carbon emissions without extra cost.

34

Figure 4: From financial value to total value

Source: Bruegel. Note: F = financial value; S = social value; E = environmental value; T = total value; T* = optimised total value. The first two bars illustrate the values based on the original production process; the final two bars show the values based on the optimised production process. The vertical axis is expressed in monetary units.

Our example in Figure 4 shows that the internalisation of

the externalities leads to an increase in the total value from

9 (bar 2) to 12 (bar 4). In the traditional finance approach,

which maximises F only, the original production process

would be continued (bar 1 at 15 is higher than bar 3 at 14)

and the additional value would not be realised. When pricing

of the externalities and/or reputation damage materialise in

the medium term, the old production process becomes obso-

lete and the new production process becomes more favour-

able. In the case of medium to long-term investments, the

assets used in the original production process might become

stranded, resulting in a loss of financial value (Caldecott et

0

2

4

6

8

10

12

14

16

18

20

-2

-4

-6

-8

-10

F15

S3

E3

T9

F14

S1E1

T* 12

35

al, 2014). To avoid this risk, companies (and their financiers)

might start to internalise the externalities before the gov-

ernment (pricing, regulation), the employees (strike, talent

drain) or the public (reputation, customer strike) do so.

Box 5 gives an example of how a sector can apply the total

value methodology, also called the true price methodology,

to products and make changes over the full value chain.

Box 5: The true price of roses from Kenya (Source: True Price, 2014)

A true price analysis was conducted to identify a business

case for sustainable rose farming (True Price, 2014). The

study covered T-hybrid roses of 20 grams from Lake Naivasha

in Kenya and compared roses produced at a conventional

farm to those produced at a sustainable farm. Mapping the

supply chain showed that the retail prices of roses produced

on both types of farms are on average the same (€0.70). The

true price on the other hand was much lower for the sustain-

able rose (€0.74) than the conventional rose (€0.92). This dif-

ference in true price mainly stemmed from the environmen-

tal impact associated with transporting the roses via airfreight

and the social impact in terms of workers’ incomes.

The true price analysis identified various projects to

reduce environmental and social costs:

• Transport by ship to reduce carbon emissions;

• Solar powered greenhouse to reduce non-renewable

energy use;

• Closed-loop hydroponics to reduce water and fertiliser

usage;

• Training on health and safety to improve workers’ skills;

36

• Gender committees to reduce harassment and gender

discrimination;

• Pay a basic living wage to improve the wellbeing of

workers.

The true price analysis maps the costs of each project and

its effect on the profit and loss of an average farm. For exam-

ple, health and safety training would generate about €4,500

profit per hectare, while switching to transport by sea would

increase profit by €5,000 per hectare. Better social standards

for rose-farm workers and more environmentally friendly

growing and transportation techniques are financially feasi-

ble, without negatively affecting farm owners’ bottom lines.

Some improvements in social standards, such as paying

a living wage to workers, were less feasible if farm owners

would have to bear all the costs. Based on an economic

value chain analysis, it was shown that providing a living

wage could be possible when a fraction of the costs are

borne by wholesale traders, retail traders and consumers.

This strengthened the promotion of better social and envi-

ronmental standards.

While the monetisation of externalities helps to bring soci-

etal and environmental externalities into corporate deci-

sion-making, there are several caveats to the market-driven

calculation of total or true value. First, monetisation cannot

fully express the ethical aspects of externalities, such as

human rights or health and safety (KPMG, 2014). The three

capitals (financial, social and environmental) are also not

substitutable. Next, working out total value can lead to

37

perverse outcomes: the negative environmental impact of

deforestation, for example, can be offset by large economic

gains (legitimising destruction). To avoid these outcomes,

we incorporate the constraint that the social-environmen-

tal value cannot be reduced compared to its initial value. A

final issue is participation (Coulson, 2016). Producers could

involve stakeholders in the application of the true-value

methodology to form a more inclusive and pluralist concep-

tion of risk and values for social and environmental impacts.

Sustainable Finance 2.0 comes in different shapes.

Examples are triple bottom line (people, planet, profit) and

integrated profit and loss accounting. Within corporate gov-

ernance, we can speak of an extended stakeholder approach,

whereby not only direct stakeholders, such as shareholders,

suppliers, employees and clients, but also society and envi-

ronment, as indirect stakeholders, are included.

3.5 SF 3.0: Contributing to sustainable development,

while observing financial viability

Sustainable Finance 3.0 moves from risk to opportunity.

Rather than avoiding (very) unsustainable companies from a

risk perspective, financial institutions invest only in sustain-

able companies and projects. In this approach, finance is a

means to foster sustainable development, for example by

funding healthcare, green buildings, wind farms, electric car

manufacturers and land-reuse projects. The starting point of

SF 3.0 is a positive selection of investment projects based on

their potential to generate positive social and environmental

impacts. In this way, the financial system serves the sustaina-

ble development agenda in the medium to long term.

The question that then arises is how the financial part of

38

the decision is taken. An important component of sustainable

development is economic and financial viability. Financial

viability, in the form of a fair financial return (which at the

minimum preserves capital), is a condition for sustainable

investment and lending; otherwise projects might need to be

aborted prematurely because of financial shortfalls. The key

change is that the role of finance turns from primacy (profit

maximisation) to serving (a means to contribute to sustainable

development). It moves from the front row to the back row.

What is a fair financial return? Of the respondents to the

Annual Impact Investment Survey (GIIN, 2016), 59 percent

primarily target risk-adjusted, market-rate returns. Of the

remainder, 25 percent primarily target below market-rate

returns that are closer to market-rate returns, and 16 percent

target returns that are closer to capital preservation. So the

great majority pursues market, or close to market, returns,

while a small group accepts lower returns for sustainability

reasons.

More broadly, the question is whether investors (includ-

ing the ultimate beneficiaries, such as current and future

pensioners) are prepared to potentially forego some financial

return in exchange for social and environmental returns (eg

enjoying their pension in a liveable world). Social preferences

play an important role for investors in socially responsible

investment (SRI) funds, while financial motives appear

to be of limited importance (Riedl and Smeets, 2017). SRI

investors expect to earn lower returns from SRI funds than

from conventional funds, suggesting that they are willing to

forego financial performance in order to invest according to

their social preferences. However, it is ex ante not clear what

the ultimate effect of impact investing is on financial return.

39

If investor coalitions, for example, could accelerate the

transition towards sustainable development, there would be

less chance of negative financial returns because of extreme

weather events or stranded assets. This argument depends on

sufficiently large amounts of investment moving to sustaina-

ble finance (see section 5).

Moving to corporate governance, legitimacy theory under-

pins Sustainable Finance 3.0. Legitimacy theory indicates

that companies aim to legitimise their corporate actions in

order to obtain approval from society and thus, to ensure their

continuing existence (Omran and Ramdhony, 2015). This

social licence to operate represents a myriad of expectations

that society has about how an organisation should conduct its

operations. The corporation thus acts within the bounds and

norms of what society identifies as socially responsible behav-

iour, including meeting social and environmental standards.

3.6 Comparing the stages: where are we?

The three stages of sustainable finance lead to different levels

of realised social-environmental value. Sustainable Finance

1.0 introduces a minimum level, SEV min, below which

investors cannot go. Companies or investment projects that

do not meet this minimum level are on an exclusion list. The

next stage, Sustainable Finance 2.0, balances the privately

discounted financial, social and environmental value in an

overall approach based on evaluating the total value. We

label this SEV private. For illustration purposes, we incorporate

this privately discounted social-environmental value halfway

along our social-environmental value scale in Figure 5.

Finally, Sustainable Finance 3.0 maximises the social-envi-

ronmental value, SEV optimal. Companies and projects, which

40

deliver this maximised social-environmental value, are eligi-

ble for investment (inclusion list).

Figure 5: Levels of social-environmental value (SEV)

Source: Bruegel. Note: SEV min = minimum level of social and environmental value; SEV private = maximised total value (= privately discounted financial, social and environmental value); and SEV optimal = maximised social and environmen-tal value.

The first two stages aim to avoid reputation risk, as

the public demands a minimum level of corporate social

responsibility and externalities are expected to be priced-in

at some stage. The third stage aims to grasp the opportunities

of realising social-environmental impact through investment

and lending.

Where are we currently on the social-environmental

axis? The majority of firms are at the Sustainable Finance

1.0 level, putting financial value first. About 30 to 40 percent

of financial institutions and 20 percent of companies adopt

sustainable principles in their investment and business

practices (see Table 4). But these firms are only partly

(fraction α) maximising total value. They are somewhere

in between Sustainable Finance 1.0 and 2.0, which can be

expressed as: max V = (1 - α) F + α T = F + α (S + E), in which

V stands for the overall value maximised by the firm, F for

financial value, T for total value (T = F + S + E), S for social

value and E for environmental value.

A fair approximation is that financial value is dominant

SEV

0% SEVmin

SEVprivate

SEVoptimal 100%

41

and social-environmental value is incorporated for about 10

percent (α = 0.1). This implies that we are just above, but still

quite close, to SEV min. To increase the social-environmental

value, the real issue is to switch from Sustainable Finance 1.0

to Sustainable Finance 2.0. Box 6 reports on a recent battle

between the shareholder model (SF 1.0) and the stakeholder

model (SF 2.0). Finally, the group of financial institutions

adopting Sustainable Finance 3.0 is tiny, at less than 1 percent

(Table 4).

The framework is dynamic. Non-governmental

organisations (NGOs) put pressure on investors to raise the

minimum level by expanding the number of exclusions. The

introduction of government regulation or taxation on social

and environmental externalities can cause an upward shift

of the social-environmental component in the total value

calculation.

Box 6: The aborted take-over of Unilever by Kraft Heinz

In February 2017, Kraft Heinz, the US food company,

attempted to take over Unilever, the European food company

(Financial Times, 2017). A deal would have brought together

two companies with radically different business models and

cultures. With a stable of slower-growing brands, Kraft Heinz

is heavily concentrated in the US and underpinned by debt-fi-

nanced deals. It implemented aggressive cost-cutting strate-

gies to generate margin expansion that allowed it to repay the

debt and bolster shareholder returns (shareholder model).

Meanwhile, Unilever is better known for its strong brands and

presence in some of the biggest emerging markets. Under its

chief executive, Paul Polman, Unilever attempted to focus on

42

better balancing profitability with social and environmental

sustainability (stakeholder model).

This was a big take-over battle. Kraft Heinz offered $143

billion for Unilever, but Unilever did not want to give up its

sustainable business model. In the end, Warren Buffett, the

big financier behind Kraft Heinz, did not approve a hostile

takeover and stopped the bidding of Kraft Heinz for Unilever.

In the aftermath of the aborted take-over, a debate started

on the ‘protection’ of companies with stakeholder models

against the aggressive bids of shareholder-model compa-

nies. Defences against takeovers, such as certified shares or

priority shares with friendly shareholders, can reduce market

discipline, which in turn might decrease the stock price of

the company. We propose a societal cost-benefit analysis,

including financial, social and environmental factors, based

on the total or true value methodology (De Groot Ruiz and

Schoenmaker, 2017). It is the responsibility of the manage-

ment of both the acquiring and target company to conduct

this test. Similar to the fairness opinion of an investment

bank as to whether the terms of a merger or acquisition are

fair, an independent advisor would give a fairness opinion on

the outcome of the societal cost-benefit test. A Commercial

Division of the Court or a Take-Over Panel (as in the United

Kingdom) would only approve a take-over or merger if and

when this cost-benefit test showed a positive value for soci-

ety. When necessary the Court or Panel could appoint experts

to re-calculate the societal cost-benefit test.

4 OBSTACLES TO SUSTAINABLE FINANCE

A move towards sustainable finance requires a transition

away from the current financial system. What are the main

obstacles to, and incentives for, adopting sustainable finance?

Table 3 provides an overview of the sustainability players,

including the instruments at their disposal, forums in which

they might work together, and the opportunities and threats

they face. While our focus is primarily on the role of investors4

and companies, we include also governments, civil society

(NGOs) and households in Table 3 for completeness. This

section discusses two main obstacles to sustainable finance:

insufficient collective effort and a bias towards the short term.

Section 5 discusses the opportunities for sustainable finance.

4 We use the term investors as shorthand for financial institutions, including pension funds, insurance companies, fund managers, private equity and banks.

44

Tabl

e 3:

Pla

yers

in s

usta

inab

ility

Pla

yer

Sph

ere

of

infl

uen

ceH

oriz

onM

ech

anis

ms

Lea

din

g or

gan

isat

ion

s an

d c

oop

erat

ion

foru

ms

Op

por

tun

itie

sTh

reat

s

Gov

ern

men

tC

oun

try

/ G

lob

alU

p to

4

year

sSt

ron

g le

ader

ship

ro

le•

Taxa

tion

• R

egu

lati

on

Un

ited

Nat

ion

s:

UN

FCC

C C

OP,

New

Yor

kE

con

omy

wid

e im

pac

tP

ub

lic r

ole

in

ener

gy a

nd

in

fras

tru

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re

Shor

tfal

l of e

ffor

tsM

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g cl

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e p

led

ges

Pol

icy

diff

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ces

Free

rid

er b

ehav

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Civ

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ciet

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om

MT

to

LT

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blic

voi

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f NG

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• M

edia

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cial

cap

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esel

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on

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am, O

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dA

mn

esty

Inte

rnat

ion

al,

Lon

don

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, Am

ster

dam

WW

F, W

ash

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on D

C

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nd

a se

ttin

gSt

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late

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tize

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f in

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ors

and

co

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gle

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end

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n g

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will

of

(loc

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gove

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ST to

LT

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rm in

vest

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• In

vest

men

t str

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din

g st

rate

gy•

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gage

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t

PR

I, L

ond

onFC

LT G

lob

al, B

osto

nG

INN

, New

Yor

kG

AB

V, Z

eist

Stim

ula

te

corp

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e su

stai

nab

ility

Stew

ard

ship

an

d

enga

gem

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Shor

tfal

l of e

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ts

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t-te

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m: m

onth

ly /

q

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mar

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gM

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eatm

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f ill

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id in

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nat

ive

sou

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of

fin

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: ret

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earn

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spon

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Mon

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45

Pla

yer

Sph

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of

infl

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ceH

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ech

anis

ms

Lea

din

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s an

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por

tun

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sTh

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s

Cor

por

ates

Val

ue

chai

n

of p

rod

uct

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From

M

T to

LT

Key

pla

yers

for

tran

sfor

mat

ion

• P

rocu

rem

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• P

rod

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ion

pro

cess

WE

F, D

avos

WB

CSD

, Gen

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Rep

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bu

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gSo

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d a

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sin

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pra

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tfal

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tric

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seh

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sC

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From

ST

to

LT

Ulti

mat

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uyin

g de

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ectin

g g

over

nmen

t

Con

sum

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ssoc

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ons

Stee

r co

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estm

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e fo

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of t

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per

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n fo

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s or

larg

e p

laye

rs a

re li

sted

for

illu

stra

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pu

rpos

es. C

OP

= C

onfe

ren

ce o

f th

e Pa

rtie

s (g

over

ned

by

the

UN

FCC

C);

WW

F =

Wor

ld W

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nd

; PR

I = P

rin

cip

les

for

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pon

sib

le In

vest

men

t (su

pp

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d b

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e U

N);

FC

LT

Glo

bal

= F

ocu

s C

apit

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n th

e L

ong

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Glo

bal

; GII

N =

Glo

bal

Imp

act I

nve

stin

g N

etw

ork;

GA

BV

= G

lob

al A

llian

ce fo

r B

anki

ng

on V

alu

es;

WE

F =

Wor

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46

4.1 Insufficient private effort

While the adoption of sustainable business and finance prac-

tices is a major advance towards sustainable development,

it might not be sufficient for two reasons. First, the fallacy of

composition arises when one concludes that something is

true of the whole (macro) from the fact that it is true of every

part (micro). Even if individual companies internalise social

and environmental externalities, it is not certain that the

planetary boundaries are not crossed. One example is the

current drive of companies to reduce their carbon footprints.

This eco-efficiency push is a welcome trend in itself, but the

available evidence suggests that the projected trajectories

for carbon emissions exceed the allowable carbon budget

for staying below 2o Celsius of global warming (eco-effec-

tiveness). Dyllick and Muff (2016) called this discrepancy

the “big disconnect”. Busch, Bauer and Orlitzky (2016) also

made the paradoxical observation that increasing sus-

tainable investment does not necessarily spur sustainable

development, and call for a system perspective, which we

explore in section 5.

There are several reasons for the divergence between the

micro and macro outcomes. First, financial institutions and

companies use a private discount factor to discount future

cash flows. Stern (2008) argues that the public discount factor

should be very small or zero because the government should

value current and future generations equally. Because social

and environmental impacts are particularly felt in the long

term, private discounting leads to insufficient effort from

a social welfare perspective. Next, only about 20 percent of

companies are actively managing their carbon footprints to

some extent (Table 4). These micro efforts are not enough to

47

keep carbon emissions within the allowable carbon budget at

the macro level.

Second, the boundary problem compounds the challenge

of internalising externalities. When regulation for one sector

is tightened, business will shift to other sectors and countries

with fewer or no requirements (Goodhart, 2008). Exemptions

in the EU emissions trading system, such as airlines operating

between EU and non-EU countries, highlight the boundary

problem (as well as the international coordination problem)

in environmental regulation. Other examples are national

regulations for products, which companies can circumvent

by relocating production to less-strict countries. A solution

to this problem might be the use of product or activity-based

regulation (Schoenmaker and Wierts, 2015).

Another way to address the boundary problem would

be to monitor and mitigate financial imbalances across

the entire financial sector. Schoenmaker and Van Til-

burg (2016) proposed that central banks and supervisors

should monitor systemic financial imbalances resulting

from ecological pressures building up and concentrating

in financial institutions and markets. Supervisors can,

for example, use carbon stress tests for a whole range of

financial institutions to identify overexposures to, and con-

centrations in, carbon-intensive assets, which include not

only the oil, gas and coal sectors but all sectors using fossil

fuels as an input either in the production or in the use of

their products (eg car manufacturers) and services. These

carbon stress tests make use of various climate scenarios,

including the adverse scenario of late adjustment resulting

in a ‘hard landing’, and have a long horizon over which

adverse events could occur.

48

Finally, there are limits to what the private sector can

achieve. While financial institutions are starting to look at

social and environmental externalities, there is clearly a role

for government to make finance fully sustainable through

regulation and taxation of these externalities. The starting

point is that much of the transition is driven by private invest-

ment, but that investment is threatened by government-in-

duced risk (Stern, 2015). Policies, governance and institutions

create a risk-return balance on the basis of which investors

decide whether or not to act. But it is government policy,

including the stability and credibility of policy, that creates

the framework for that investment and sets out a range of

pricing and regulatory instruments to encourage the low-car-

bon transition. Stern (2015) adds that making sound policy is

not just about the analysis and implementation of incentives,

but also about social and personal responsibility and values.

Moreover, the role of communities is often undervalued.

Only with the involvement of community can we recycle

and reuse. Interesting examples of the sharing economy (eg

car-sharing schemes) are emerging. The role of private coali-

tions for sustainable finance is explored in section 5.

We are in the transition to a low-carbon, circular econ-

omy. The externalities of the current carbon-intensive

economy are becoming increasingly clear to the wider public

(eg more catastrophic weather events, droughts and flooding

in countries close to the equator, air pollution). A case in

point is California, where air pollution from heavy traffic in

the 1990s prompted environmental regulations and stimu-

lated innovation, for example in the electric cars of Tesla and

in solar technology. China, India and Mexico, for example,

face similar, or even worse, air pollution today, which may

49

prompt at some point stricter environmental regulations in

these countries. Finance is about anticipating such events

and incorporating expectations into today’s valuations, which

underpin investment decisions. Finance can thus contribute

to a swift transition to a low-carbon economy.

4.2 Short-termism

The tragedy of the horizon is a major obstacle to sustainable

finance (Carney, 2015). The costs of action are borne now,

while the benefits are in the future. The impact of economic

activity on society, and even more so on the environment, is

typically felt in the long term. By contrast, the horizons that

managers and investors in conventional finance work to are

mostly short-term. As indicated in the right-hand column of

Table 3, several practices reinforce short-termism (which we

deal with in turn later in this section):

• Quarterly financial reporting by companies;

• Variable pay systems based on annual results;

• Monthly or quarterly benchmarks for measuring investor

performance;

• Marking-to-market of investments;

• Supervisory treatment of illiquid investments.

These practices make the transition to sustainable finance

difficult. There is a trade-off between using markets as a

disciplining device for managers and investors and designing

measures or incentives that foster their long-term behav-

iour. A common theme behind these practices is the widely

accepted efficient markets hypothesis, which states that stock

prices incorporate all relevant information and thus on

50

average reflect the long-term fundamental value of the firm

(Fama, 1970). The efficient markets hypothesis reinforces the

focus on stock price as a central performance measure for

executive and investor performance.

An alternative to the efficient markets hypothesis is the

adaptive markets hypothesis (Lo, 2015). Contrary to the

neoclassical view that individuals maximise expected utility

and have rational expectations, an evolutionary perspec-

tive makes considerably more modest claims. The degree

of market efficiency depends on an evolutionary model of

individuals adapting to a changing environment. Prices

reflect as much information as dictated by the combination

of environmental conditions and the number and nature of

distinct groups of market participants, each behaving in a

common manner and having a common investment horizon.

For example, retail investors, institutional investors, market

makers and hedge fund managers can be seen as distinct

groups with differing investment horizons. If multiple groups

(or the members of a single highly populous group) are com-

peting within a single market, that market is likely to be highly

efficient. If, on the other hand, a small number of groups are

active in a given market, that market will be less efficient. The

adaptive markets hypothesis can explain why new risks, such

as environmental risks, are not (yet) fully priced in, as not

enough investors are examining these new risks5.

5 Andersson, Bolton and Samama (2016) argued that there is little awareness of carbon risk among (institutional) investors, and it is thus not priced by the market. Hong, Li and Xu (2016) investigated whether stock markets efficiently price risks brought on or exacerbated by climate change. Their findings support regulatory concerns that markets that are inexperienced with climate change underreact to such risks. Hong, Li and Xu (2016) thus call for corporate expo-sure to climate risks to be disclosed.

51

Quarterly financial reporting

There is ample evidence that the majority of firms view

quarterly earnings as the key metric for an external audience,

more so than the underlying cash flows (Graham, Harvey and

Rajgopal, 2005). The pressure created by a high reporting fre-

quency to continuously achieve a strong share price induces

managers to adopt a short-term perspective (myopia) in

choosing the firm’s investments. Such pressures disappear

when the reporting frequency is decreased. Infrequent

reports could provide better incentives for project selection

decisions even though they provide less information to the

capital market (Gigler et al, 2014). Nevertheless, timely pub-

lication of information that has a material impact on a firm’s

performance remains important.

Barton and Wiseman (2014) recommended focusing on

metrics like ten-year economic value added, R&D efficiency,

patent pipelines and multiyear return on capital investments.

More generally, the nature of financial reporting should be

broadened. Integrated reporting is a process founded on

integrated thinking within a firm that results in a periodic

integrated report about value creation over time, and related

communications regarding aspects of value creation. Inte-

grated reporting facilitates transparency of social and envi-

ronmental aspects. The current process is largely bottom-up

(with the exception of South Africa, which already requires

integrated reporting): some firms have started to publish

integrated reports. However, the quality and reliability of the

reported information differs significantly. To speed-up this

process, the Financial Stability Board set up the Bloomberg

Task Force to provide a set of voluntary, consistent disclo-

sure recommendations for use by companies in providing

52

information about their climate-related financial risks to

investors, lenders and insurance underwriters (Task Force

on Climate-related Financial Disclosures, 2017). At some

point, best practices need to be incorporated into binding

international accounting standards, adopted by the Inter-

national Accounting Standards Board (IASB) and supported

by the International Organisation of Securities Commis-

sions (IOSCO). Finally, integrated reports would need to

be audited, according to these future standards, to provide

assurance of the reported information.

Variable pay systems

Executive directors’ bonuses based on annual results or paid

in stock options reinforce the focus on short-term results

(Edmans et al, 2017). More broadly, executives are primarily

concerned with the direct impact of investments during their

tenure, as current performance is a key factor for their career

prospects. To address this short-term bias, a more long-term

oriented pay structure for executives can be introduced. The

deferred reward principle suggests that pay for exerting effort

in the current period is spread over the current and future

periods to achieve intertemporal risk-sharing. The payment

of all or part of a bonus can thus be deferred and made

contingent on subsequent events, such as the completion of a

major strategy or project when the full impact of the invest-

ment becomes clear. Also the vesting period (or the lock-up

period) for equity compensation can be lengthened, even

after retirement. Another powerful tool is clawback provisions

in executive compensation whereby an employer takes back

money that has already been disbursed, sometimes with an

added penalty (Bolton and Samama, 2013). Clawback provi-

53

sions can be activated in case of fraud or accounting errors,

but also in cases where subsequent losses show in hindsight

that the executives received excess compensation.

Quarterly performance benchmarking

Fund managers are evaluated on a regular basis against per-

formance benchmarks. The quarterly relative performance

monitoring to which many funds and fund managers are

subject results in the adoption of short-termist attitudes and

approaches to the management of funds (Baker, 1998). More-

over, a greater proportion of institutional investors simply

pursue passive, broad asset-class-allocation investment

strategies, which means that a smaller fraction of sharehold-

ers is informed about any individual firm and its fundamental

long-term value.

To overcome short-term interests, performance evaluation

should be aligned with the time horizon of the investment

strategy and underlying investments. Bolton and Samama

(2013) proposed to introduce loyalty shares, which provide an

additional reward to shareholders if they have held on to their

shares for a contractually specified period of time, the so-called

loyalty period (eg three, five or ten years). More specifically,

Bolton and Samama (2013) suggested a reward in the form of a

warrant giving the right to purchase a pre-determined number

of new shares at a pre-specified price and granted to loyal

investors at the expiration of the loyalty period. A major benefit

of incentives for investors to hold their shares for the long-term

is that it facilitates engagement of (institutional) investors with

companies (see section 5).

An early example of a loyalty share was Michelin in 1991,

which granted loyalty shares in the form of warrants following

54

a dividend cut to compensate the most loyal shareholders for

this loss of income (Bolton and Samama, 2013). Specifically,

Michelin granted one call warrant for every 10 shares held

on 24 December 1991, with a two year loyalty period. The call

warrant was exercisable at a four year horizon (31 December

1995) at an out-of-the-money strike price (ie a strike price – at

which the warrant can be exercised – well above the share

price) of 200 French francs, compared to a share price of

about 115 francs at the time of the announcement (Figure 6).

Figure 6: Call warrant for loyal shareholders (Michelin share price and

warrant strike)

Source: Bolton and Samama (2013). Note: The share price and warrant strike are in French francs (vertical axis). The loyalty period covered two years from end-1991 to end-1993, after which loyal shareholders received the warrant. The subsequent warrant subscription period, in which they could exercise the warrant, was from end-1993 to end-1995.

0

50

100

150

200

250

300

12/1

991

03/1

992

06/1

992

09/1

992

12/1

992

03/1

993

06/1

993

09/1

993

12/1

993

03/1

994

06/1

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09/1

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12/1

994

03/1

995

06/1

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09/1

995

12/1

995

Share price

Warrant strike

Start ofloyalty

End of loyalty period,start of warrant

subscription period

End of warrantsubscription period

55

Marking-to-market

Market prices give timely signals that can aid decision-mak-

ing. But in the presence of distorted incentives and illiquid

markets, there are other harmful effects that inject artificial

volatility into prices, which distorts real decisions. When

markets are only imperfectly liquid in the sense that sales or

purchases affect the short-term price dynamics, the illiquidity

of the secondary market causes another type of inefficiency

(Plantin, Sapra and Shin, 2008). A bad outcome for the asset

will depress fundamental values somewhat, but the more

damaging effect comes from the negative externalities gener-

ated by other firms selling. Under a mark-to-market regime,

the value of someone’s assets depends on the prices at which

others have managed to sell their assets. When others sell,

observed transaction prices are depressed more than is

justified by the fundamentals, exerting a negative effect on all

others, but especially on those who have chosen to hold on

to the asset. Anticipating this negative outcome, a short-ho-

rizon investor will be tempted to pre-empt the fall in price

by selling the asset itself. However, such pre-emptive action

will merely serve to amplify the price fall. In this way, the

mark-to-market regime generates endogenous volatility of

prices that impedes the resource allocation role of prices. This

process can be in particular at work during times of crises.

The alternative, the historical cost regime, also leads to

inefficiencies, as there are no adjustments for subsequent

changes in the market values of assets. Assessing the pros and

cons, Plantin, Sapra and Shin (2008) found that the damage

done by marking to market is greatest when claims are (i)

long-lived, (ii) illiquid, and (iii) senior. For junior assets trad-

ing in liquid markets, such as traded stocks, marking-to-mar-

56

ket is superior to historical cost in terms of the trade-offs. But

for senior, long-lived and illiquid assets and liabilities, such

as bank loans and insurance liabilities, the harm caused by

distortions can outweigh the benefits. Banks loans are, for

example, typically carried at historic or nominal value, with

deduction of expected credit losses (ie impairments).

In the aftermath of the global financial crisis, the interna-

tional accounting standard for financial instruments (IAS 39)

was amended to exempt financial instruments from fair value

accounting, when they are managed on an amortised cost

basis in accordance with a financial firm’s business model.

To keep the appropriate perspective, the fair value discussion

focuses on a subset of assets (ie financial instruments) and on

unusual circumstances. Shleifer and Vishny (2011) consid-

ered fire sales, where fair value accounting reinforces the

downward spiral and is thus counterproductive. The unusual

circumstances should be confined to these instances when

the markets are clearly illiquid, otherwise undue forbearance

may arise. The benefit of fair value accounting is that man-

agement and regulators get a clear signal from the markets

prompting them to act. Several studies (eg Laux and Leuz,

2010) argue that fair value accounting did not play a major

role in the financial crisis.

Supervisory treatment

Liquid investments, which can be traded and thus marked

to market on a daily basis, carry a relatively low supervisory

capital charge, as financial firms can divest these assets at

short notice. The supervisory treatment is based on mark-

ing-to-market, liquidity and efficient market measures.

By contrast, private market and direct investments carry a

57

higher capital charge to cater for the ‘risk’ that the investment

cannot be liquidated at short notice. Environmental projects

typically have a long horizon and cannot be measured on a

frequent basis. The results are only visible after a period of

time. Land restoration projects, for example, have a horizon

of twenty years (Ferwerda, 2016). When regulated financial

institutions hold an investment to maturity, solutions to avoid

or reduce the need for a supervisory surcharge for illiquidity

can be found in measuring the potential and the risk of a

project over the full cycle of that project (eg using scenario

analysis) rather than on a daily mark-to-market basis. Also at

the retail level, there is bias towards liquid and transferable

securities. Box 7 provides a proposal for sustainable retail

funds.

Box 7: Sustainable retail funds6

The main vehicle for retail investors is the Undertakings for

Collective Investments in Transferable Securities (UCITS;

2009/65/EC). UCITS are collective investment funds operat-

ing freely throughout the European Union on the basis of a

single authorisation. The UCITS concept is based on a small

set of core criteria: 1) diversification rules; 2) concentration

limits; 3) transferability of listed securities; and 4) strictly

regulated use of derivatives for protection purposes only.

The transferability requirement assumes a liquid market

in the respective securities. An overreliance on market liquid-

ity is misguided. Shleifer and Vishny (2011) analysed the role

of asset ‘fire sales’ in depleting the balance sheets of finan-

6 I would like to thank Linda van Goor for the idea of sustainable retail funds based on the UCITS concept.

58

cial institutions and aggravating the fragility of the financial

system during the 2007-08 financial crisis. Assets sold in fire

sales can trade at prices far below value in best use, causing

severe losses to sellers. While liquidity is useful for retail

investors, we suggest that the notion that only listing provides

sufficient liquidity be revised into a concept of ‘liquidity that

ensures a balanced control of in- and outflow of cash by fund

managers’ combined with a withdrawal limit on fund shares.

This would acknowledge that fund managers should hold a

diversified buffer of liquid assets consisting of different asset

categories that they can use to cover short-term liquidity

needs.

The objectives of the EU capital markets union (CMU)

include among others fostering retail investment in capital

markets and harnessing finance to deliver sustainability

(European Commission, 2015). To reach out to retail inves-

tors, the European Commission could prepare legislation

for setting up liquid, sustainable retail investment funds

or undertakings with a EU-passport. The UN Sustainable

Development Goals (see Box 4) could be used to incorporate

sustainability in the investment criteria of these funds. Such

‘Undertakings for Collective Investments in Sustainable

Securities’ (UCISS) would keep the UCITS’ diversification

rules and concentration limits, as well as the strictly regulated

use of derivatives for protection purposes only. For liquidity,

UCISS would replace the requirements of listing and trans-

ferability with the concept of sound liquidity management, ie

balanced control of in- and outflow of cash by fund manag-

ers. Finally, UCISS would incorporate a definition of eligible

investments that meet enforceable sustainability criteria.

59

In summary, a possible cost of financial markets is short-ter-

mism, with agents in the financial intermediation chain

giving near-term outcomes too much weight at the expense of

longer-term opportunities. There is evidence that stock prices

in the UK and the US have historically over-discounted future

dividends by 5 to 10 percent, suggesting significant evidence

of myopia (Davies et al, 2014). Possible incentive-compatible

solutions to counter short-termism would be more long-term

oriented pay structures for executives (eg clawback provisions

and deferred rewards) and incentives for long-term investors

(eg loyalty shares). Moreover, the reliance on mark-to-market

valuations should be reduced.

5 COALITIONS FOR SUSTAINABLE FINANCE

A classic problem in environmental economics is the

tragedy of the commons. This refers to the situation within

a shared-resource system when individual users acting

independently according to their own self-interest, behave

contrary to the common good of all users by depleting that

resource through their collective action. Common resources

are not only natural resources, which can be depleted,

but also the use of the air or water as sinks, which can be

overused. A standard approach to preserve a common good

is government taxation or regulation (top row of Table 3)

or vesting of private property rights. However, an exclusive

regulatory approach towards curbing carbon emissions has

been elusive to date.

5.1 Coalitions as an alternative

Ostrom (1990) looked beyond centralised regulation by

external authorities or private property rights as the means to

govern common pool resources. She offered design princi-

ples for how common resources can be governed sustainably

and equitably in a community. The central idea is to build

coalitions, which develop rules governing the use of the

common good, monitor members’ behaviour, use graduated

61

sanctions for rule violators and provide accessible means for

dispute resolution. The key to build an effective and inclusive

coalition is to define clear group boundaries, whereby the

major parties are covered, and to ensure that those affected

by the rules can participate in modifying the rules (Ostrom,

1990). As suggested in this essay, the rules governing the

use of a common good, such as the available carbon budget,

should follow a system approach.

The efforts to limit climate change provide an illustration

of the proposed system approach. Currently, countries make

climate pledges within the framework of the annual confer-

ences of the parties (COPs) to the United Nations Framework

Convention on Climate Change (UNFCCC, 2015). The aggre-

gated climate pledges so far (technically called the Nationally

Determined Contributions) still imply likely global warming

of more than 2oC (UNFCCC, 2016), but there is an expecta-

tion that countries will increase their pledges over time (the

ratchet effect)7 as part of predefined five-year review cycles.

For instance, within the overall COP framework, compa-

nies could introduce a global sub-COP framework with a

downward trajectory of corporate carbon budgets under the

auspices of the World Economic Forum (WEF) or the World

Business Council for Sustainable Development (WBCSD)

(see Table 4 and Figure 7)8. Private and public corporations

(including utilities) would be included.

7 The ratchet effect refers to escalations in price or production that tend to self-perpetuate. Once prices have been raised, it is difficult to reverse these changes, because people tend to be influenced by the previous best or highest level.8 This idea emerged in discussions with Patrick Bolton.

62

Figure 7: Coalitions for sustainable finance

Allianz AM SSGA UBS Vanguard BlackRock Others

Bank Tokyo Bank of Am. BNP Paribas HSBC JPM Others

CPPIB Schroders APG SSGA BlackRock Others

0%10%20%30%40%50%60%70%80%90%

100% Company AUM (US$b)1 BlackRock 5,1172 Vanguard Group 3,8143 UBS 2,7714 State Street Global Advisors 2,4465 Allianz Asset Management 2,086Others 45,766Total 62,000Total global AUM* 163,000Conventional global AUM 108,500

Asset managers: Principles for Responsible Investment

74%

Company AUM (US$b)1 BlackRock 5,1172 State Street Global Advisors 2,4463 APG  4984 Schroders  4905 CPPIB 279Others 982Total 9,812Total global AUM* 163,000Conventional global AUM 108,5000%

10%20%30%40%50%60%70%80%90%

100%

Asset managers: Focusing Capital on the Long Term Global

10%

Company Assets (US$b)

1 JPMorgan Chase 2,491

2 HSBC Holdings 2,375

3 BNP Paribas 2,190

4 Bank of America 2,188

5 Bank of Tokyo 1,982

Others 34,733

Total 45,959

Global banking assets 152,9610%

10%20%30%40%50%60%70%80%90%

100%

Banks: Equator Principles

76%

GLS Triodos Amalgamated Vancity GCC Others

BP Toyota Volkswagen Shell Walmart Others

0%10%20%30%40%50%60%70%80%90%

100%

Banks: Global Alliance for Banking on Values

Company Revenues (US$b)

1 Walmart 482

2 Shell 272

3 Volkswagen 237

4 Toyota 237

5 BP 226

Others 7,123

Total 8,577

Fortune 500 total revenues 27,6340%

10%20%30%40%50%60%70%80%90%

100%

Corporations: World Economic Forum

Company Revenues (US$b)

1 Walmart 482

2 Shell 272

3 Volkswagen 237

4 Toyota 237

5 Apple 234

Others 3,769

Total 5,230

Fortune 500 total revenues 27,6340%

10%20%30%40%50%60%70%80%90%

100%

Corporations: World Business Council for Sustainable Development

Company Assets (US$b)

1 Group Credit Cooperatif 26

2 Vancity 18

3 Amalgamated Bank New York 18

4 Triodos Bank 14

5 GLS Bank 5

Others 30

Total 110

Global banking assets 152,961

28%

Apple Toyota Volkswagen Shell Walmart Others

83%

72%

63

Source: See Table 4.

Figure 7: Coalitions for sustainable finance

Allianz AM SSGA UBS Vanguard BlackRock Others

Bank Tokyo Bank of Am. BNP Paribas HSBC JPM Others

CPPIB Schroders APG SSGA BlackRock Others

0%10%20%30%40%50%60%70%80%90%

100% Company AUM (US$b)1 BlackRock 5,1172 Vanguard Group 3,8143 UBS 2,7714 State Street Global Advisors 2,4465 Allianz Asset Management 2,086Others 45,766Total 62,000Total global AUM* 163,000Conventional global AUM 108,500

Asset managers: Principles for Responsible Investment

74%

Company AUM (US$b)1 BlackRock 5,1172 State Street Global Advisors 2,4463 APG  4984 Schroders  4905 CPPIB 279Others 982Total 9,812Total global AUM* 163,000Conventional global AUM 108,5000%

10%20%30%40%50%60%70%80%90%

100%

Asset managers: Focusing Capital on the Long Term Global

10%

Company Assets (US$b)

1 JPMorgan Chase 2,491

2 HSBC Holdings 2,375

3 BNP Paribas 2,190

4 Bank of America 2,188

5 Bank of Tokyo 1,982

Others 34,733

Total 45,959

Global banking assets 152,9610%

10%20%30%40%50%60%70%80%90%

100%

Banks: Equator Principles

76%

GLS Triodos Amalgamated Vancity GCC Others

BP Toyota Volkswagen Shell Walmart Others

0%10%20%30%40%50%60%70%80%90%

100%

Banks: Global Alliance for Banking on Values

Company Revenues (US$b)

1 Walmart 482

2 Shell 272

3 Volkswagen 237

4 Toyota 237

5 BP 226

Others 7,123

Total 8,577

Fortune 500 total revenues 27,6340%

10%20%30%40%50%60%70%80%90%

100%

Corporations: World Economic Forum

Company Revenues (US$b)

1 Walmart 482

2 Shell 272

3 Volkswagen 237

4 Toyota 237

5 Apple 234

Others 3,769

Total 5,230

Fortune 500 total revenues 27,6340%

10%20%30%40%50%60%70%80%90%

100%

Corporations: World Business Council for Sustainable Development

Company Assets (US$b)

1 Group Credit Cooperatif 26

2 Vancity 18

3 Amalgamated Bank New York 18

4 Triodos Bank 14

5 GLS Bank 5

Others 30

Total 110

Global banking assets 152,961

28%

Apple Toyota Volkswagen Shell Walmart Others

83%

72%

64

The starting point could be the pledged carbon reductions

of the largest companies (eg the Fortune 500). The Bloomb-

erg principles for climate-related financial disclosures could

be used for yearly reporting and monitoring of corporate

progress (Task Force on Climate-related Financial Disclo-

sures, 2017). This system approach would thus be based on a

mix of top-down calculation of the overall sustainable carbon

budget and bottom-up declarations of carbon reduction

intentions by companies.

As part of their intensifying corporate governance

approach, long-term asset managers, such as pension funds

and insurance companies, can stimulate companies to

operate within the ‘system’ boundaries and can hold them

accountable. To ensure companies stay within these bound-

aries or budgets, asset managers also need to report the

carbon footprint (as well as other environmental and social

dimensions) of their investments. Next, asset managers need

to cooperate on engagement with companies by forming

investor coalitions on long-term sustainable investment

(McNulty and Nordberg, 2016). Examples of long-term inves-

tor coalitions are the Principles for Responsible Investment

(PRI), Focusing Capital on the Long Term Global (FCLT

Global), the Global Impact Investing Network (GINN) and

the Global Alliance for Banking on Values (GABV). Figure 7

provides an overview of these investor coalitions, including

the five largest members. This overview shows that the mem-

bers are drawn from North America, Europe and Asia. These

coalitions have thus the potential to become a global force

for change. The long-term focus of these coalitions would

include avoiding environmental and social hazards, which

materialise over the medium to long term, and grasping the

65

opportunities offered by low-carbon investment which pays-

off in the long term. Engagement is a very powerful tool to

improve social and environmental standards in the corporate

sector, where the social and environmental externalities are

caused (Skancke, 2016). The ultimate aim is to steer business

to truly sustainable practices spurred by a macro perspective.

5.2 Reasons to join coalitions for sustainable finance

What are the incentives for long-term investors to join these

emerging coalitions for sustainable finance? One incentive

is that members can seize the opportunities of the transition

towards a sustainable economy. The members of PRI, FCLT

Global, GIIN, GABV and WBCSD are intrinsically motivated to

work on long-term value creation (see Table 4). Other investors

might be prompted by NGO campaigning and/or pressure

from their peers to join these coalitions. Next, investors might

be incentivised to join in order to avoid the risk of stranded

assets (Litterman, 2015). Collective advocacy by an investor

coalition to push governments to clarify their agendas on, for

example, climate mitigation (including timing of regulations

and taxes) could reduce policy-related uncertainty over the

future value of assets (Skancke, 2016). Such clarity over future

policies would also help to stimulate investment in new clean

technologies and projects. Finally, Dimson, Karakas and Li

(2015) provided evidence that collaboration among activist

investors is instrumental in increasing the success rate of social

and environmental engagements.

As a follow-up to the pioneering work of Ostrom (1990) on

design of institutions for governing common resources, we

recommend further research on building effective coalitions

for sustainable finance in parallel with regulatory initiatives

66

to address the social and environmental externalities. Private

and public initiatives can reinforce each other. Private action

can pave the way for public rules and taxes. In turn, public

endorsement can strengthen private coalitions. To start this

broad research agenda, we make an initial assessment of the

main coalitions for sustainable finance (Table 4). For asset

management, we take PRI, FCLT Global and GINN. For bank-

ing, we include the Equator Principles for project finance and

GABV. For companies, we take WEF and WBCSD. Following

the design principles developed by Ostrom (1990), we exam-

ine the following features of the coalitions:

1. Clearly defined boundaries: which percentage of the

relevant group is covered by the coalition;

2. Congruence between provision rules and local con-

ditions: membership rules restricting the use of the

common good are related to local conditions; this can be

translated into the sustainable finance typology that the

coalition follows;

3. Collective choice arrangements: individuals affected by

the operational rules and principles can participate in the

modification of these rules and principles;

4. Monitoring: reporting on meeting the rules and princi-

ples and assessment of the extent to which the rules and

principles are followed;

5. Sanctions and rewards: how to punish violations by mem-

bers or to reward those members that comply; and

6. Conflict resolution mechanism: members and their offi-

cials have rapid access to low-cost local arenas to resolve

conflicts between members or between members and

officials.

67

Tabl

e 4:

Coa

litio

ns fo

r sus

tain

able

fina

nce

Coa

litio

nC

over

age

(in

%)

Sust

ain

able

fi

nan

ce

typ

olog

y

Col

lect

ive-

choi

ce

arra

nge

men

tM

onit

orin

gG

rad

uat

ed

san

ctio

ns

or

rew

ard

s

Con

flic

t-re

solu

tion

m

ech

anis

ms

PR

I38

.0%

1)

1.0

/ 2.

0Ye

s, s

ix p

rin

cip

les

for

resp

onsi

ble

inve

stm

ent a

nd

m

and

ator

y re

por

tin

g

Yes,

ass

essm

ent r

epor

tsO

nly

for

the

boa

rdN

o

FCLT

G

lob

al6.

0% 1

)1.

0 /

2.0

No,

bu

t col

lect

ive

goal

to

en

cou

rage

lon

g-te

rm

beh

avio

ur

in b

usi

nes

s an

d

inve

stm

ent

Part

ly, d

emon

stra

ted

co

mm

itm

ent t

o lo

ng

term

va

lue

crea

tion

for

new

m

emb

ers

No

No

GII

N0.

05%

1)

3.0

Part

ly, a

ctiv

itie

s to

su

pp

ort

imp

act i

nve

stin

gN

oN

oN

o

Eq

uat

or

Pri

nci

ple

s30

.0%

2)

1.0

/ 2.

0Ye

s, p

rin

cip

les

sett

ing

out

a fr

amew

ork

for

man

agin

g en

viro

nm

enta

l an

d s

ocia

l ri

sk in

pro

ject

s

Yes,

req

uir

emen

t to

rep

ort;

E

P a

ssoc

iati

on a

sses

ses

com

plia

nce

wit

h r

epor

tin

g re

qu

irem

ents

, bu

t doe

s n

ot

veri

fy c

onte

nt

No,

co

mp

lian

ce

wit

h p

rin

cip

les

resp

onsi

bili

ty

of m

emb

ers

No

GA

BV

0.07

%2.

0 /

3.0

Yes,

pri

nci

ple

s of

su

stai

nab

le b

anki

ng

Yes,

sco

reca

rd to

mea

sure

th

e ec

onom

ic, s

ocia

l an

d

envi

ron

men

tal i

mp

act o

f b

anks

No

No

68

Coa

litio

nC

over

age

(in

%)

Sust

ain

able

fi

nan

ce

typ

olog

y

Col

lect

ive-

choi

ce

arra

nge

men

tM

onit

orin

gG

rad

uat

ed

san

ctio

ns

or

rew

ard

s

Con

flic

t-re

solu

tion

m

ech

anis

ms

WE

F31

.0%

1.0

/ 2.

0N

o, b

ut m

issi

on b

ased

on

st

akeh

old

er th

eory

, wh

ich

st

ress

es a

ccou

nta

bili

ty to

al

l par

ts o

f soc

iety

No

On

ly fo

r th

e m

anag

ing

boa

rd

No

WB

CSD

18.9

%1.

0 /

2.0

Yes,

pri

nci

ple

s of

su

stai

nab

le d

evel

opm

ent

Yes,

cou

nci

l rev

iew

s an

d

ben

chm

arks

an

nu

al

sust

ain

abili

ty r

epor

t of

mem

ber

s

Yes,

cea

se o

f m

emb

ersh

ip

in c

ase

of n

on-

adh

eren

ce

Part

ly, c

risi

s m

anag

emen

t

Sou

rce:

Bru

egel

. Not

es: Th

e tw

o or

thre

e m

ain

coa

litio

ns

are

show

n fo

r ea

ch g

rou

p (

asse

t man

ager

s, b

anks

; cor

por

ates

). P

RI =

Pri

nci

ple

s fo

r R

esp

onsi

ble

Inve

stm

ent (

sup

por

ted

by

the

UN

); F

CLT

Glo

bal

= F

ocu

s C

apit

al o

n th

e L

ong

Term

Glo

bal

; GII

N =

Glo

bal

Imp

act I

nve

stin

g N

etw

ork;

GA

BV

= G

lob

al A

llian

ce fo

r B

anki

ng

on V

alu

es; W

EF

= W

orld

Eco

nom

ic F

oru

m; W

BC

SD =

Wor

ld B

usi

nes

s C

oun

cil f

or S

ust

ain

able

D

evel

opm

ent.

The

cove

rage

is c

alcu

late

d a

s fo

llow

s: th

e as

sets

of m

emb

ers

as p

erce

nta

ge o

f glo

bal

ass

ets

un

der

man

agem

ent a

t con

ven

tion

-al

, alt

ern

ativ

e an

d p

riva

te w

ealt

h fu

nd

s -

for

asse

t man

ager

s; a

s th

e as

sets

of m

emb

er b

anks

as

per

cen

tage

of g

lob

al b

anki

ng

asse

ts -

for

ban

ks;

and

as

reve

nu

es o

f mem

ber

For

tun

e 50

0 co

rpor

ates

as

per

cen

tage

of t

otal

rev

enu

es o

f For

tun

e 50

0 co

rpor

ates

- fo

r co

rpor

ates

. The

Sust

ain

a-b

le F

inan

ce ty

pol

ogy

(1.0

, 2.0

an

d 3

.0 fr

om T

able

2)

is b

ased

on

the

auth

or’s

ass

essm

ent.

1) C

onfi

nin

g th

e an

alys

is to

glo

bal

AU

M o

f con

ven

tion

al fu

nd

s at

$10

9 b

illio

n (

inst

ead

of g

lob

al A

UM

of a

ll fu

nd

s at

$16

3 b

illio

n),

PR

I mem

-b

ers’

ass

ets

are

57 p

erce

nt o

f glo

bal

AU

M; F

CLT

Glo

bal

mem

ber

s’ a

sset

s 9

per

cen

t; a

nd

GII

N m

emb

ers’

ass

ets

0.07

per

cen

t.

2) 8

9 b

anks

hav

e offi

cial

ly a

dop

ted

the

Eq

uat

or P

rin

cip

les,

cov

erin

g ov

er 7

0 p

erce

nt o

f in

tern

atio

nal

Pro

ject

Fin

ance

deb

t in

em

ergi

ng

mar

kets

.

69

Table 4 shows that the larger coalitions – covering 20 to

40 percent of the relevant reference group – are somewhere

between Sustainable Finance 1.0 and 2.0. These coalitions

include social and environmental factors in their decision-mak-

ing, alongside the financial factor. It is interesting to note that

members progressively tighten the principles in subsequent

versions, providing a dynamic component to these coalitions

– some sort of virtuous cycle. However, not all coalitions have

clear principles guiding the behaviour of their members. PRI

and WBCSD have well-defined sustainability principles, which

are also monitored and are closer to Sustainable Finance 2.0

than the other coalitions (FCLT Global, the Equator Principles

and WEF). Next, the coalitions adopting Sustainable Finance

3.0 put social and environmental factors first and the financial

factor second. The coverage of these advanced coalitions is very

small with less than 1 percent of the relevant group covered. We

classify GABV in between Sustainable Finance 2.0 and 3.0 as

GABV stresses the triple bottom line (2.0) – people, planet and

prosperity – as well as social and environmental challenges (3.0).

There is clearly an inverse relationship between the degree of

sustainability and the size of the coalition.

A key aspect is monitoring of the coalition members. On

this feature, the picture is very diffuse. Some coalitions leave

monitoring and reporting explicitly to the members (eg the

Equator Principles Association), while the WBCSD explicitly

reviews and benchmarks its members’ annual sustainability

reports. The WBCSD even threatens to expel members that do

not meet the ‘membership conditions’. Most of the coalitions

have a conflict resolution mechanism. Only the WBCSD has

a mechanism for conflicts of interests and can form a crisis

management team.

70

Finally, as short-termism is one of the main barriers to

sustainable finance, we recommend that the coalitions should

adopt a long-term focus and take the time for new solutions to

develop and flourish without quarterly benchmarking.

6 CONCLUSIONS

Sustainable finance looks at how finance (investing and

lending) interacts with economic, social, and environmental

issues. This essay shows how sustainable finance has the

potential to move from finance as a goal (profit maximisa-

tion) to finance as a means. In his book Finance and the Good

Society, Shiller (2012) provides some stimulating examples

of how finance can serve society and its citizens by allocating

funding to new projects. The same could be done to address

the environmental challenges.

This essay provides a new framework for sustainable

finance. The traditional shareholder model places finance

first and has a short-term horizon, while the stakeholder

approach seeks to balance the financial, social and envi-

ronmental aspects and is more focused on the long term.

Our assessment of the current system shows that the social

and environmental factors are only partly incorporated;

the financial factor still dominates. There is also tension

between the models. To avoid a fall back to the narrow

shareholder model during takeover contests, we recom-

mend application of a societal cost-benefit test when a

shareholder-oriented firm tries to take over a stakehold-

er-oriented firm. The takeover should only be approved if

72

the test indicates a positive total value – based on financial,

social and environmental values – for society.

This essay also examines obstacles to the adoption of

sustainable finance. To address insufficient corporate efforts,

governments should adopt appropriate regulation and taxa-

tion (eg appropriate carbon taxes). Finance is about antic-

ipating such policies and incorporating expectations into

today’s valuations for the purposes of investment decisions.

To counter short-termism, we recommend several incen-

tives to align executive and investor horizons over the longer

term. On the executive side, incentive-compatible measures

include a more long-term oriented financial reporting struc-

ture (moving away from quarterly reporting) and an executive

pay structure with deferred rewards and clawback provi-

sions. On the investment side, the investment performance

horizon should go beyond the current standard of quarterly

benchmarking. Institutional investors can be incentivised

to engage with companies by providing loyalty shares if they

hold shares in the company for a loyalty period of three, five

or ten years.

Finally, we outline how long-term investors can build

effective coalitions to engage with, and exert influence on,

the companies in which they invest. In this way, long-term

investors can steer companies towards sustainable business

practices and accelerate the transformation to sustainable

development.

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Dirk Schoenmaker is a Senior Fellow at Bruegel. He is also a Professor of

Banking and Finance at Rotterdam School of Management, Erasmus University

Rotterdam. He is a member of the Advisory Scientific Committee of the European

Systemic Risk Board at the European Central Bank and a Research Fellow at the

Centre for European Policy Research. He has published in the areas of central

banking, financial supervision and stability, European financial integration and

climate change.

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